Thursday, May 08, 2008

When we heard about Alderaan...

Yesterday's market sell off walked and talked a little like the fear trading that dominated the first quarter of 2008. Particularly the sudden drop in the stock market around 2:30 with no real explanation looked a little spooky. Recent market rallies in both stocks and credit have been 100% about a modest decline in risk aversion. The belief was that the worst case scenario had been taken off the table, so while the real economy isn't good, the panicky market gyrations were no longer justified. Could that improved sentiment reverse? Was yesterday the start of something bad?

Well, we speak bonds here, and there are some interesting, and maybe telling, indicators from the bond markets. First, CDS moved significantly wider yesterday. The CDX.IG.10 index (which is a basket of investment-grade CDS) moved 10bps wider, the biggest single day widening since April 8. I haven't seen the final CDX number, but should be 1-2bps wider today. That would mark the fourth day in a row in which the IG index moved wider. I'd characterize a single-day move of 10bps as pretty extreme, although during the January-March period, there were several 20bps single-day moves.

Brokerage credits, which were at the epicentre of the fear trades, were also wider on Wednesday. Lehman +5, Merrill +6, Morgan Stanley +3 and Goldman +7. Broker paper was largely unchanged today. Here is were the movement didn't look much like the pre-Bear Stearns world, with brokerage paper outperforming the market generally.

Cash bonds, which you may remember are those things with coupons and maturities that people used to trade in the olden days, were little changed. Lehman's new senior 10-year note was bid as tight as +275 and as wide as +290 on Tuesday, but settled in at +285 and was stuck there through Wednesday and Thursday. When you see cash bonds unchanged and CDS wider, its most likely that fast money is pushing the market. Real money tends to buy cash bonds, fast money tends to play in derivatives. That seems especially true given that the CDX indices underperformed typically high beta individual names.

Meanwhile, non-credit spreads were well-behaved. Interest rate swap spreads were tighter, with both the 2 and 10-year spread moving about 1.5bps tighter, and followed through today moving another 3bps tighter. Fannie Mae senior debt spreads, which had moved about 6bps wider on Tuesday after their ugly earnings report, moved 3bps tigher on Wednesday and another 3bps tighter on Tuesday.

So what's the conclusion? The Fed really changed the game when they bailed out Bear Stearns and opened their balance sheet up to the remaining investment banks. The "run on the bank" scenario has been rendered impossible. So a return to the fear trading of January-March wouldn't make a lot of sense.

A better explanation is that the market is struggling to price a world where liquidity is improving but real economics are deteriorating. It felt to me like the market, especially stocks, had become a bit too optimistic in recent days, with some even talking like we won't have any recession at all.

Don't confuse economic data that's "better than expected" with "good." Now if you ask me where the stock and credit markets will be in a year, I'd say both will be better than today. Looking one year out, we'll probably be through this recession, housing will have bottomed, and there will be much more earnings clarity. But in the near term, I think we need a little more of a recession concession.


Anonymous said...

AI: A better explanation is that the market is struggling to price a world where liquidity is improving but real economics are deteriorating.

As you pointed out, the "fast" money (trading CDS) was doing entirely different things than the "real" money.

People who work on Wall Street may or may not be corrupt, depending who you ask, but as a group they aren't stupid. They all know two indisputable truths about their employers:
1) A good many of them have Level 3 assets (the unpricable garbage) that is several multiples of share holder equity. And this is before one subtracts "good will" from the assets column (which represents how much excess banks paid in their acquisition binges). In short, a good many of the big banks are insolvent. Having access to funding from the Fed does not change this

2) Many banks' business models can be boiled down to this: enter into a negative gamma trade (mortgages, credit, whatever), and lever the living crap out of it. Most of the time, things work out and you collect your little spread (multiplied by your leverage) and life is good. But a couple times per decade, you get one of these extreme events (call them Black Swans if you insist) and the options you are short take you to the cleaners.

Many banks have lost more money in the last 9 MONTHS than they made in the last 7-8 YEARS. If your business is not profitable through a full business cycle -- then its not really a business. It means your "profits" in the early years failed to include sufficient charges for future write-offs.

Bernanke can pretend like banking is still a business, but in the wise words of Watergate's Deepthroat: follow the money. Consider Citibank. The Latin America debt crisis. Bad loans in the oil patch (that took down Continental Illinois). Bad LBO debt. Real estate problems in the early 1990s (remember the prince of Saudi Arabia had to bail them out?). Then they had all the legal / investment banking issues that led Sandy Weill to leave. And of course: this latest mortgage snafu.

These "unprecedented" disasters keep happening every 7-8 years.

Going forward, its something of a foregone conclusion that the Fed will not allow anywhere near the same amount of leverage that was used in the past. Even 20-1 leverage is just a problem waiting to happen.

So what exactly is Wall Street's business model now? The short gamma trade is over-subscribed. The really narrow spreads offered by spread products won't float Wall Street unless they are levered a lot.

Even if they won't say so out loud, everyone knows there is a big problem.

BTW - Warren Buffet has been sitting on something close to $40 billion in cash for some time now. The major banks are trading at less than half what they were a year ago. If banking's future was bright, you would think the world's smartest long term investor would snap this stuff up and then wait for the dust to settle.

Well, he bought a bubble gum company instead.

Anonymous said...

Anon 7:06

You forgot one important consideration about buying banks / investment banks...

The traders call.

Heads I make 15% of my P&L, tails I either collect my minimum or I get fired and move to some other bank.

If the bank I work for is capital constrained, I can't put on as many trades. If the CEO is randomly laying off people as part of his cost cutting "growth" strategy, there is reasonable probability I may get fired / laid off regardless of my performance.

It makes a lot of sense for "level B" and "level C" traders (not the top guys) to put on a few "Hail Mary" trades and hope for the best.

Irregardless, the airline industry tells us a lot about how an industry performs when a large number of the members are bankrupt. They don't operate the same way as would a profit maximizing firm.

And all Wall Street employees now need to consider, if not focus on, career risk. Its far more important than duration or gamma-- its not the employees money on the line, but it is his/her career.

Anonymous said...

"I'd say both will be better than today"
If by better you mean a nominal increase in valuation, does this mean you don't anticipate a hike in the Fed Funds rate in 1Q09? I thought they might have to raise rates, but would appreciate your response.

Also, anon 7:06 PM's Even 20-1 leverage is just a problem waiting to happen comment prompts me to ask, yet again, what you think a prudent leverage ratio might be for our financial institutions.

Unknown said...

The "run on the bank" scenario has been rendered impossible.

Not really. The Fed is making it easier to obtain liquidity if a run starts -- but as with Bear Stearns, the Fed can't force anyone to do business with a bank that looks too wounded.

Over the years, there have been fatal runs on commercial banks that had access to the discount window. Continental Illinois, for example.

Accrued Interest said...


Impossible may not be literally correct, but I stand by the concept.


Yes I see the Fed hiking sometime in early '09. Don't see if happening in '08, as I don't see the economy bottoming that quickly.

Even if you take an extremely optimistic view of housing, I think we have to remember that the housing market is going to move at a glacial pace. It isn't like the financial markets where good/bad news can move the markets 10% in a week. It looks like home prices will take about 1.5-2 years to bottom at a minimum. So I'd say we could see another 1-2 years of flat prices on top of that.

Anonymous said...

One note about recent CDS vs. cash performance:
Since the wides in mid-March, IG CDS has outperformed the cash market dramatically. The basis between CDS and cash went from +30 (CDS 30 wider than cash) to -60 yesterday. This fast money led short covering rally leaves much of the synthetic market extremely unattractive from the long perspective, particularly for real money investors setting up for a very busy new issue calendar. So if I want to get long credit, I'll buy the next new issue that prices 50-100bps cheap to CDS rather than selling protection on a CDS contract that will get whipped around at the slightest deterioration in market sentiment. But if I want to get short or take off some risk? CDS is looking pretty cheap...

Anonymous said...

Anon 7:06

That was just about the most concise, spot-on analysis of big banks I've seen anywhere.

Anonymous said...

hi AI

can you comment on the signficance of the "non-credit" spreads i.e. swap spreads that you touched on?
what are the implications on swap spreads re: credit etc?


PNL4LYFE said...

I definitely agree with BD's assessement of cash vs CDS. A lot of dealers and fast money were short (long protection) and the short covering rally was very gappy. On the days with the most tightening, most of the activity was in the street on low volume. Now that the pain is over for them, I think we'll drift wider until we find the right level. I don't know what the right level is, but 200 on IG is too wide and 80 was too tight.

viking said...

Your analysis of recent events is spot on. Your forecasting is too optimistic.

Housing will have bottomed by a year?

Like, 2009. Dude even the NAR says it will take longer than that.

I can tell you that in the toney parts of California, the bottom is 2011. And a lot of the bottom lit hit in defaults is still in front of us. Most, in fact.

You are right in saying the game has changed. Totally has. No more runs on the banks possible.

We have a much bigger problem. Inflation in gas and food. Economy contracting. At all time highs of consumer debt to GDP. Unemployment clearly in uptrend. Interests rates about to move materially higher.

And to top it off, another 20% to fall in the national house median.

The real economic downturn is just starting. It won't be two quarters.

Accrued Interest said...

On CDS: I totally agree about CDS/cash. Basis packages and massive technicals are heavy influences. But my point stands that you shouldn't read too much into CDX widening.

On housing: I don't have a lot of conviction in a forecast of how long it will take for housing to bottom. Its a little easier to make a guess about how far it should fall. Seems like 20-25% nationally is right to me. I know most of the blogosphere is more bearish than that :).

Anyway, I find it very difficult to figure whether it will take 1 or 2 or 3 years to fall that much. My view is 1.5-2 years, but I just don't feel strongly about that.

For what its worth, the guy who claimed housing has already bottomed in a WSJ op-ed is high on crack. The piece wasn't even very good, I don't know why the WSJ printed it. I mean, I've read stuff I strongly disagree with, but is well-reasoned. This wasn't even well-reasoned.

Anonymous said...

Psychodave: prompts me to ask, yet again, what you think a prudent leverage ratio might be for our financial institutions.

I am not sure there is a single leverage ratio that applies across the board. It seems to me that every market experiences a sell-off of 7-8 percent from time to time (even if its a temporary sell off).

To give yourself a margin of safety (does anyone in finance even remember that phrase?) I would suggest a 10-1 leverage ratio would be the absolute max -- that lets you survive a 10% pullback in your market.

If you trade a more volatile market that experiences wider swings, you would need a much smaller ratio.

If you trade something that doesn't really have a value, your creditors (if they have any brains) will value your assets erring on the conservative side -- meaning a 20% swing in perceived value would not be unexpected-- that means a leverage max.

Yes, I know AI or somebody is going to try to argue that CDOs and SIVs and whatever toxic waste doesnt really change value by 20% -- its just people panicking. Perhaps so, but the price of your security is whatever another person will pay for it.

That brings you to the next consideration. If you are dependent on short term financing (like most banks and hedge funds)-- you need a smaller leverage ratio, all else equal.

Your securities/collateral are worth what your creditors think they are-- your opinion is not relevant since you are the debtor. You need their money to stay in business, so your opinion doesnt count.

If you are fortunate enough to have longer term financing, than you are less subject to short term market fluctuations, and perhaps your leverage can be closer to the "max" levels above.

Incidentally, most of these banks and hedge funds spend hours everyday analysing their trading risks (SocGen maybe not so much).

If a trader had on a MASSIVE curve flattening trade, like as big as the firm's total assets -- you would hope the risk guys would raise a red flag.

Well, if you are borrowing short term (short the 3m sector) and investing the money long term (long the 10yr sector) -- what the hell trade do you think you have on?!?!

Even if they don't recognize it as such, all these banks and hedge funds were in bet-the-farm curve flattening trades. Bet the farm, because their obscene leverage meant that the implied curve flattener trade (via their financing) was almost the size of their total assets.

I hope it is obvious that one shouldn't bet 95% of your assets on a single trade (assuming the 20-1 leverage, many banks were even higher than that).

Anonymous said...

AI: what are your thoughts on FNMA / FHLMC?

It seems to me these two are the mother of all monoline insurers, subject to far more risk in aggregate than Ambac or MBIA.

On top of that, they have on massive mortgage positions-- everyone else on Wall St lost money on these in recent months, its impossible that the two largest players could hedge better than everyone else.

And on top of that, these guys are levered to an extent LTCM would think ridiculous. Roughly $5 TRILLION in assets backed by less than $90 billion in equity. It works out to a leverage ratio of almost 60-1!!!

And now Congress/OFHEO want them to lever up even MORE?

If you are right about the housing market (and I think you are) -- how is this going to end anything other than a full blown govt bailout of the GSEs?


Anonymous said...

@anon 10:56 AM
Thanks, you are most helpful.

Anonymous said...

Historically I think the average housing bubble takes about 7 years from peak to trough. This being the mother of all bubbles, I wouldn't be surprised if it took 15 years to hit the trough.

There may be many more shocks along the way... a Fannie and Freddie implosion, a 2nd recession, an oil supply shock, a war, etc.

Accrued Interest said...

On the GSE's: A parallel between monolines and GSE's doesn't work. The overwhelming majority of monoline losses have been on CDO^2 and ABS CDOs. The GSE's primarily insure first lien prime MBS. So it really isn't comparable. The GSE's are so much larger, of course, so their absolute losses have been gigantic. But in terms of losses as a percentage of assets (not equity) its still tiny.

I'm not sure if it ends in a bailout. So far the GSE's have been able to raise large amounts of capital without difficulty. The government will never have to step in as long as outside investors are willing to do so. If you subscribe to some of the more dire predictions on housing, then the GSE losses will be too large to be handled by the market and thus the UST will have to step in.

But under mainstream forecasts for housing, the GSE's have plenty of cash. So if you want my view, its that the GSE's aren't that bad off in terms of credit.

Accrued Interest said...

On duration of housing bubble:

What previous housing bubble are you speaking of? Because there has been nothing like this in the past. We've sure never seen housing fall in 7 straight years in the post Depression era.

Sajal said...

I think the low volatility over the last 5 years lulled the banks into having excessively high leverage. Their risk models used unusually low volatility numbers which enabled them to take on assets on their balance sheet.